U.S. stocks, as measured by the S&P 500 Index, delivered positive returns for the second quarter of 2016. It wasn’t easy getting there though; three days before the end of June stocks were showing a loss for both the quarter and year-to-date period. It took a 5.6% rally over the last three days of June to save the quarter.

As seen in the table below, the past year has been difficult for most stock indices. The S&P 500 is the only index shown that has produced positive returns for the past 12 months. To get those 4.0% returns, investors had to endure not only the recent volatility in late June, but also two 10% corrections, one occurring last August and one this past January. During this period, U.S. small caps generated modest loses, while both developed and emerging international markets suffered double-digit declines.

The table below shows the performance of major equity indices for various time periods.

Equity Performance for Periods Ending on June 30, 2016

Total Return Index Market Sector Quarter YTD 1-year 3-year 5-year 10-year
S&P 500 Large U.S. Companies 2.5% 3.9% 4.0% 11.7% 12.1% 7.4%
Russell 2000 Small U.S. Companies 3.8% 2.2% -6.7% 7.1% 8.4% 6.2%
MSCI EAFE Developed Int’l Markets -2.6% -6.3% -12.7% -0.6% -1.2% -1.3%
MSCI EM Emerging Int’l Markets -0.3% 5.0% -14.2% -3.9% -6.2% 1.1%

Looking at the 10-year performance, one might conclude that it makes no sense to invest in international markets considering their dismal performance. However, shifting from poor performing sectors to the best performing sectors rarely works out well, since each sector moves through different cycles. For example, three years ago emerging markets had the best performing 10-year annualized rate of return, generating average annual returns of 11.0%, compared to the 7.3% for the S&P 500. Over the following three years, emerging markets became the worst performing sector. Without a doubt, there will be some point in the future when international markets return to favor and deliver superior returns.

Stock markets around the world demonstrated a considerable amount of volatility during the second quarter especially in the last two weeks of June. The decision of British voters to leave the European Union was blamed for a loss of roughly $3 billion dollars in global stock market value in the two trading days following the vote. The referendum, known as Brexit, had two simple options: remain a member the European Union or leave. While polling prior to the vote indicated a lack of consensus, stock markets clearly seemed surprised and disappointed by the outcome. And if there is anything that markets hate more than surprises, it would have to be uncertainty. With the resignation of Prime Minister David Cameron and a lack of visibility regarding the actual exit from the E.U., global markets dropped sharply.

The S&P 500 Index fell 5.3% in the two trading days following the vote and then recovered 91% of that loss in the next three days. After the initial panic, investors surmised the U.K. exit might not be a big deal after all, especially for U.S. investors. The biggest risk is probably that U.K.-inspired protectionism might lead to less foreign trade which could cause slower global growth over the long term. Considering that the U.K. represents less than 1% of the world population and just 3.5% of global GDP, and that most U.S. citizens would be hard pressed to find something in their home that was made in the U.K, the stock market’s decline seemed to be a bit of an overreaction.

While the U.K. and the rest of Europe are important components of the world economy, they have not been significant contributors to world GDP growth and their outlook for near-term growth is very modest. The IMF (International Monetary Fund) estimates Europe will have average annual GDP growth of only 1.8% over the next five years. This pales in comparison to the expected GDP growth of emerging market economies, which continue to be the primary driver of world economic growth. (Average annual GDP growth for emerging market economies is forecast to be 4.9% over the next five years.) Currently 87% of the world population lives in an emerging market, and as globalization continues, these people will play a growing role in the global economy. For example, China, the largest emerging market, contributed 35% of world GPD growth over the past five years, and according to the IMF, is forecast to generate about 30% of world growth over the next five.

The Brexit episode demonstrated the general inability to predict the direction of the market, and more specifically, the danger of panicking in reaction to dramatic news. While it’s easy to point to this episode as an example of irrational investor behavior, the research firm Dalbar has attempted to quantify the penalty investors pay for similar mistakes. Dalbar measured the performance of mutual fund investors by tracking monthly fund purchases, sales, redemptions, and transfers. For the 20-year period ending December 31, 2014, the average investor who invested in U.S. equity funds earned average annual returns of 5.2%. This compares to 9.9% for the S&P 500 Index for the same time period. The underperformance of fund investors can be attributed to a number of mostly psychological and emotional factors, including the tendency of investors to chase trends (buying high or selling low without regard to the underlying value of an investment), inaccurate assessment of risk, and trading in reaction to a news event.

The recent stock market gyrations demonstrate that it is probably best to ignore the market’s short-term volatility and the news that creates it. It is obvious that the market tends to overreact to both good and bad news and is extremely short-term focused. However, good long-term equity performance is generally achieved by owning reasonably valued, well-managed companies that have competitive advantages within their respective industries. A successful long-term investor needs to accept (or ignore) the short-term volatility that comes with owning equities.

The economic data in the second quarter was largely mixed. Although the most recent employment report showed weak job growth, the unemployment rate fell from 5.0% to an eight-year low of 4.7%, and the average wage rate increased at a relatively strong 2.5% pace. While the initial report for first quarter GDP showed a very weak 0.5% growth rate, this number was revised upward twice with the final number coming in at 1.1%. All of the major U.S. based banks passed the recent Federal Reserve stress tests and were given the green light to increase dividends and repurchase shares.

While surprise events like the Brexit vote can play havoc with the market, we anticipate continued volatility going forward as there are a number of on-going uncertainties that concern investors. Among these issues are the outcome of the U.S. presidential election, sluggish corporate earnings in the U.S., struggling economies in Europe and Japan, and slowing growth in China. In order to stimulate growth, most major central banks are continuing policies aimed at keeping interest rates low. While the continued dependency on central bank policy concerns us, low interest rates are generally positive for equity investors. Low interest rates reduce borrowing costs for corporations and their customers. They also make stocks more attractive relative to bonds. For example, currently more than 60% of companies in the S&P 500 have a higher yield than the 10-year Treasury bond.

The yield on the 10-year Treasury bond declined during the second quarter from 1.79% to 1.49%, indicating a general concern that the U.S. economy is slowing and that rates will remain low longer than previously expected. The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, generated returns of 2.2% for the second quarter. We continue to regard longer-term fixed income investments as relatively unattractive, as we believe that rates will inevitably rise.

Rather than attempting the impossible task of predicting the market’s short-term direction, we believe that it is best to control the risk associated with equities by maintaining adequate diversification and setting an asset allocation that appropriately reflects an investor’s risk tolerance. Utilizing fixed income investments in a portfolio lowers overall risk and also allows an investor to take advantage of stock market corrections by rebalancing a portfolio when stock allocation declines.

John D. Frankola, CFA

The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.